Maintaining for your firm's financial and structural stability during and after Covid-19

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Zulon Begum
CM Murray, London
zulon.begum@cm-murray.com

Wendy Chung
CM Murray, London
wendy.chung@cm-murray.com

During Covid-19

The International Monetary Fund (IMF) predicts that the enforced lockdown across the globe due to the Covid-19 pandemic will be far worse than the Great Depression of the 1930s. To prepare for the looming recession, nicknamed ‘the Great Lockdown’[1] by the IMF, law firms of all shapes and sizes should ensure that they have constitutional measures in place to mitigate against the risks of financial and structural instability.

Many law firms affected by a lockdown around the globe have adapted to remote working across their workforce and have embraced technology and social media to maintain and enhance their profile and to keep in touch with existing clients and referrers of work. Law firm leaders will now need to plan for and implement measures to strengthen and protect their firms’ financial position and structural stability to maximise the chances of surviving the Great Lockdown and thriving in the aftermath. In addition to maintaining a steady income stream and pipeline of work, the key objectives for firms will be to:

• manage cash flow and prevent a cash crunch;
• retain and encourage high-performing partners and prune the partnership where necessary; and
• protect against the destabilising effects of partner departures

Measures to meet these objectives can usually only be implemented if the necessary powers have been delegated to senior management under the firm’s constitution and governance arrangements (such as a partnership agreement, articles of incorporation or association or partnership policies) or a partners’ resolution passed in accordance with the firm’s constitution. If the powers have not been granted, the firm may need consent from each of its partners (which can be challenging in normal trading conditions let alone during a lockdown and an economic crisis).

Manage cash flow and prevent a cash crunch

Many corporate M&A and real estate deals have been put on hold indefinitely. Clients are taking longer to pay legal fees and some are no longer able to pay. New engagements are becoming harder to win as clients reduce discretionary legal spending to protect their own cash reserves. To combat the devastating impact of a cash crunch, a law firm’s constitution should ideally contain powers for senior management to implement measures to preserve cash and access funding without having to go through a lengthy and formal partner approval process. The most useful constitutional powers include:

• discretion to reduce partners’ monthly drawings or any fixed profit shares;
• ability to defer undistributed partner profits;
• ability to defer any financial entitlements of former partners (such as their annuity, capital, tax reserve, partner loans and any undistributed profits);
• calling for additional capital contributions from partners;
• using partner tax reserves as working capital for the firm;
• discretion to secure external debt financing;
• the ability for senior management to adjust or limit partners’ expenditure; and
• the power to impose part-time working arrangements with a reduction in remuneration or profit share or unpaid/reduced pay sabbaticals.

Retain high-performing partners and prune the partnership where necessary

Law firms are built around their people and cannot afford to lose high-performing partners, who will be vital to helping firms to generate a pipeline of work to get through the Great Lockdown. Firms need to ensure that partner performance is assessed against key performance indicators (KPIs), which are effective in motivating and incentivising partners in the current environment. KPIs may need to be more focused on:

• recovery rates and profitability;
• lockup periods between billing a client and receiving payment from the client;
• cross-referral of work and opportunities across the firm; and
• business development initiatives.

If a partner is failing to perform to the expected level (even with adjustments to take into account the difficult trading conditions of a recession), the firm will need constitutional powers to manage and take appropriate actions, which may include powers for senior management to:

• issue and require a partner to comply with a written warning;
• reduce a partner’s points, units, fixed or variable profit share or voting rights (on a permanent or temporary basis); or
• demote or de-equitise a partner.

Some firms may need to remove partners who are damaging the firm’s reputation or profitability (for example, a partner guilty of misconduct or a persistently underperforming partner). To remove the partner, the firm must have the power to do so under its constitution and such power must be exercised in accordance with the terms of the constitution and the applicable local law (such as laws against discrimination and any laws relating to the duties between partners).

Unless the firm has an express power to compulsorily retire or expel a partner (usually by giving a specified period of notice or on the occurrence of specified events, such as the partner being found guilty of gross misconduct), the firm may find it difficult to remove the partner and its only option may be to negotiate an agreed exit package with the partner concerned. In the current environment, this is likely to be difficult as the prospect of a partner being able to secure another position is limited. In such cases, firms may need to be prepared to offer substantial financial inducements for a partner to leave.

Protect against the destabilising effects of partner departures

The sudden departure of a key partner can have a significant impact on a firm’s finances and future income. The firm may also be required to repay a large sum of capital contributed by the exiting partner or even a retirement annuity. The exiting partner’s client base and team (which may include other key partners as well as lawyers and support staff) may end up moving with that partner to a competitor.

Where permissible by local law and professional rules, the firm’s constitution should include the following provisions to protect the firm:

• Notice period: notice periods for voluntary retirement in large and mid-sized law firms in Europe typically range between six and 12 months (but in some jurisdictions, can be longer or shorter). In the United States, notice periods can be as short as 30 days. Firms should consider whether their notice period is appropriate and sufficient to protect the firm in a financial crisis.
• Waiting lounge: limits can be placed on the number of partners who can resign in a specified period. This gives the firm control over which partners can leave and when they can do so.
• Restrictive covenants: these restrictions stop a former partner from carrying out certain activities for a specified period (usually between six and 24 months in some European jurisdictions), such as working for a competitor, soliciting existing and potential clients and poaching existing employees and partners away from the firm. Such restrictions need to be carefully worded to ensure that they are enforceable under the applicable law.
• Garden leave: it may be helpful for the firm to have the ability to lock a partner out of the business during their notice period so that the firm can effect an orderly transition of client relationships and matters without interference from the outgoing partner and to reduce the risk of the partner soliciting clients or poaching staff and other partners.
• Good/bad leavers: good behaviour can be encouraged and bad behaviour can be discouraged by offering preferential payment terms for good leavers and less attractive terms to bad leavers (for example, by repaying capital to bad leavers over a longer period after their exit from the firm).